Wednesday, April 6, 2011

The Only Way to Day TradeThere are four cardinal principles which should be part of every trading strategy. They are: 1) Trade with the trend, 2) Cut losses short, 3) Let profits run, and 4) Manage risk. You should make sure your strategy includes each of these requirements for success.Trade with the trend relates to the decision of how to initiate trades. It means you should always trade in the direction of recent price movement.Mathematical analysis of commodity price data has shown that these price changes are primarily random with a small trend component. This scientific fact is extremely important to those desiring to pursue commodity trading in a rational, scientific manner. It means that any attempt to trade short-term patterns and methods not based on trend are doomed to failure. It also explains why day trading is darned difficult and why almost no day trader is a long-term success.The shorter the time frame in which you examine price action, the smaller the trend component is. Commodity price action is fractal. That means that as you shorten or lengthen the time frame, price action remains similar in behavior. Thus, five-minute charts have roughly the same appearance as hourly charts, daily charts, weekly charts and monthly charts.This similarity in chart appearance convinces traders that you can day trade successfully with the same tools you use on longer-term charts. Of course, they try to use much of the arsenal of technical analysis that doesn't work on long-term charts either. Things like Oscillators, Candlesticks and Fibonacci numbers.However, even trend-following tools that work in intermediate to long-term time frames won't work in day trading. This is because the trend component is so very small in short-term data that you must use a highly effective method to overcome the costs of trading.In longer-term trading, you can let your profits run. You do it by definition or it wouldn't be long-term trading. In day trading you can only let your profits run to the end of the day. This means your average trade (the average profit of both your winning and losing trades) must necessarily be much smaller than if you could let your profits run for days, weeks or months. However, your costs of trading--slippage, commissions, the bid/asked spread and mistakes--stay roughly the same on a per trade basis. Thus, your day trading system must be much more consistent and robust to stay ahead of the costs of trading than would an intermediate to long-term system. There are few day trading approaches that meet this test.Since market price action is mostly random, successful trading methods must somehow exploit a non-random feature of market price action. The tendency of most markets to trend is the only possible edge in trading, so a winning approach must harness trend in some way. Tradeable trends do not show up often in the very short term. They certainly are not present every day. That is why the person who tries to day trade at least once every day, and perhaps even more often, is doomed to failure. The more often you day trade, the more likely it is that you will be a long-term loser.There is a wonderful fantasy about day trading. You get up in the morning, have a nice breakfast and go to your home office. There you have a powerful computer with fancy software that brings you real-time intraday charts and quotes. You look over the day's market activity and find some promising situations. You watch the markets for awhile until a suitable trade presents itself. You pick up the phone and call your broker to make your trade entry. Then it's time to relax and grab a hearty cup of coffee or a frosty glass of juice while you watch your profits mount. By the end of the day, you are out of your position with a nice profit. Most days are profitable, although not all. You seldom have a losing week. Never a losing month. You make as much money as you need. Some days you don't bother with trading at all. You have better things to do. You play golf, sail, do lunch. You take extended vacations whenever you want. Life is sweet.There are plenty of people out there ready to sell you a day trading course or system for thousands of dollars that will show you how to implement this fantasy. The only problem is they haven't been successful traders. They make money only by selling their losing methods to others.Here's what trading legend Larry Williams said about day trading: "If you're day trading, you're going to end up frying your brain. When you go home, you're not going to be a nice person to be around. I'm already not too a nice a guy to be around. So when I do a lot of that type of trading, who would want to be around me?"All the day traders I talk with are losing money. The oscillators, the supposed support and resistance levels, all that other technical analysis stuff out there doesn't work very well in day trading. Plus I found I make more money by holding overnight and trading out of positions in the next day or two. If I've really got a strong signal, it should last for more than a few hours."Gary Smith is the only person with a documented long-term success record in day trading. He made money consistently for over ten years. However, he trades relatively infrequently, maybe once or twice a week. "Successful day trading is not an everyday affair and not a multiple trade affair," he cautions. "Inexperienced day traders simply refuse to accept this." Gary's book, published by Reality Based Trading, is called Live the Dream by Profitably Day Trading Stock Futures.I have been day trading successfully for the past couple of years using a system that trades on average only two or three times a month. I have also recently published a second day trading system that trades only once or twice a month. Of course, I make almost all my money trading with my more effective long-term systems. For me, day trading is only for fun and for a little diversification. These systems are available from our company.If you want to be a successful trader, your best chance is with a long-term, trend-following system. If you must day trade, don't do it very often. The more you trade, the more likely it is you will lose.

Market DisinformationHow long would a gambling casino be able to stay in business if most of the customers won instead of lost? The markets are no different. In order to continue to exist, the markets must operate in a way that causes most participants to lose. There would not be enough money available to pay the winners if the majority were consistently taking profits out of the markets.Gambling casinos have an advantage over the markets in that they are able to setthe rules of the game to insure that the house has a mathematical edge. The markets cannot directly control how the individual participants will play. Most commodity traders are intelligent, competitive individuals. There are seemingly unlimited sources of information about how to trade. There are powerful computers within everyone's reach to help conquer the markets. Why is it then that such a high percentage of traders still end up losing?A well-known answer is that traders cannot overcome their emotions well enough to succeed. That is certainly true. Another less well-understood reason is that the markets constantly send out "disinformation." I could not find disinformation in my dictionary, but it is a term coined in the intelligence community and now in broad use. In intelligence parlance it means false information designed to mislead and confuse the adversary.I am not suggesting that the markets have any volition or that there is a conspiracy among insiders (like the "evil" floor traders) to fool the rest of us. This is something that just happens because of the nature of markets.William Eckhardt is one of "wizards" Jack Schwager interviewed for his book, The New Market Wizards. Eckhardt was the partner of mega-millionaire Richard Dennis. It was his bet with Dennis about whether trading skill could be taught that led to the formation of the famous "turtles." Eckhardt put it this way. "The market behaves much like an opponent who is trying to teach you to trade poorly."A common formulation of this phenomenon is the concept of random reinforcement. Traders are not rewarded with a profitable trade every time they do something right, nor are they penalized with a loss every time they do something wrong.This makes it exceptionally difficult to figure out what is right and what is wrong. Compare this to an electric fence. Every time you walk by and don't touch it, you feel fine. Every time you touch it, you receive a painful shock. It doesn't take a man or animal long to learn how to relate to an electric fence.Think how much easier learning to trade would be if you automatically took a loss every time you failed to follow correct decision-making procedures. At the same time, what if you were always rewarded with a profit when you traded correctly? You would be able to learn the correct trading rules much more easily.As your opponent who is trying to trick you into trading incorrectly, the market is constantly sending you disinformation. One important piece of disinformation it sends is that the market is constantly changing its behavior so the successful trader must be vigilant to change his approach to keep pace.Have you noticed what a constant refrain this is from various trading experts? It is a common piece of conventional wisdom that no mechanical approach can be successful very long because the markets change. You are advised, therefore, to change your system to keep in tune with recent market behavior.It is in the expert's self-interest to preach this gospel. Anyone who tells you that the markets are always changing no doubt has found a "solution" to how to keep his trading method up-to-date. He probably wants to sell it to you in one form or another. If he is not selling his system, he at least can appear incredibly wise and resourceful to his audience. It is a sure thing his audience hasn't found such an elegant solution to beating the markets or they would be rich and would not have to listen to any experts.Another reason experts invariably claim the markets are forever changing is that it is a convenient excuse for poor performance. Every successful trader has numerous periods when his system or method doesn't seem to work. It is more palatable to say the markets have changed than my system isn't working right now. If your system isn't working, it implies you have failed. On the other hand, if the markets have changed, that is beyond your control. You can just "fix" your system.This is the origin of the pernicious practice of re-optimization. Let's say you have a great trading system using three moving averages. During the last five years, it has made beaucoup bucks in hypothetical historical testing. Naturally, you use a different set of moving averages for each market because each market "has its own personality." You are in tune with the markets and ready to trade.But wait! You know that the markets are constantly changing their personalities to keep traders off balance. It is only reasonable to expect that the correct moving average values will change over time in the future. So as part of your approach, you set a schedule for yourself to re-optimize the moving average values every so often.How often you decide to do this will depend on how industrious you are and how often you think the markets change their spots. Do the markets remain stable for six months, three months, one month, two weeks, two days? Whatever your answer, you will dutifully re-optimize your moving average values to keep up with those elusive markets.Let me tell you a little secret. Your system will always trade the past perfectly, but it will probably be lousy in real trading no matter how often you re-optimize it. Oh yes, you will have some extended periods of good profits. This will encourage you. The market is just sending you some of that good disinformation, encouraging you keep it up. In the long-run, absent some extraordinary luck, you will surely lose.I am not saying the market don't change. They clearly do. One of my favorite sayings about the markets is, "The future will be just like the past, only different." What I am saying is that any attempt to modify your approach to "keep up" with this change is like a dog chasing his tail.When you re-optimize your system every two weeks, you are making the assumptionthat during the next two weeks the markets will behave like the last two weeks. This is a comforting idea, but where is the evidence to support it? Research has shown just the opposite. The best system parameters for the next period are most likely not the best parameters from the previous period, regardless of the period length you choose. You are as likely to be successful choosing your parameters at random from previously profitable parameters as you are choosing the most profitable parameters.When people ask me how a system has performed in the last twelve months to get an indication of how it will perform in the next twelve months, I ask them a question. What makes you think 1997 markets will be more like 1996 markets than like 1987 markets or 1993 markets? In fact, 1997 markets are more likely to be similar to some previous year other than 1996.The purpose of this market disinformation is to cause people to be suspicious of successful trading methods and abandon them too soon. One of the most reliable traits of professional traders is the ability to stick with their system much longer than the typical loser. We all go through losing periods, no matter what type of approach we choose. We cannot increase our chances of success by constantly changing our approach. Since there are many more losing approaches than winning ones, we actually decrease our chances of success by frequently changing our system.The correct solution is to find a non-optimized approach that works over a long period of history in a wide variety of markets. To avoid over-curve-fitting, use the same rules for all markets. If you can trade it for an extended period in the future in a wide variety of markets, you are likely to be successful, although success in never guaranteed.The reason this works is that although the markets change their short-term patterns, they are still trending overall. That is your edge. If you play the trends, you will succeed in the long run. Attempting constantly to modify your system to mimic the changing patterns of the recent past will not improve your chances of success. It will more likely insure failure.Human nature is such that we are always trying to improve. I am not suggesting that you might not be able to create a better system in the future. Just don't fool yourself into thinking that it is better because it is somehow adapting to ever-changing markets. It is better because it is more profitable over a long period of time or because it trades more markets profitably.

The Mechanical Approach to TradingPeople who come to commodity trading invariably have already had success in some other field. Most of the time they have been extremely successful. Without that success they would not have accumulated the capital necessary to trade. They expect to apply the same rational approach to commodity trading which led to their previous successes. Unfortunately, it is precisely this seemingly intelligent methodology which steers them to disaster.The markets are designed to take money from the many and distribute it to the few. They could not exist otherwise. It should be obvious under those circumstances that what appeals to common sense and feels comfortable will not work. Otherwise, everyone would be rich.The amateur assumes that he can conquor the markets through superior analysis. He spends nearly all his time looking for effective ways to predict where the markets are likely to go next. I have been trading since 1975 and spent many years myself on this fruitless quest. Believe me when I say that the markets are not predictable in the sense most traders use the term. Luckily, it is not necessary to predict the markets to make money from them.The professional has had enough experience to learn the limitations of analysis. While there is a repetitive similarity to market behavior, there is just enough uncertainty to make predicting the future an impossible task. The professional knows the importance of a consistent approach to the markets. He has a concrete plan of attack. He seeks to follow existing trends rather than predict future trends.The amateur assumes the pros have a good idea where the best opportunities are. Actually, however, professionals consistently admit they have no idea in advance which trades will work. Most often the ones which look the least promising turn out to be the big winners.There is no favorite time frame for professional traders. Each finds the perspective which matches his or her trading personality. Some become floor traders who seldom hold trades for more than a few minutes. There are some floor traders, however, who hold positions much longer. Professionals trading off the floor may be day traders, intermediate-term traders or long-term traders. What is consistent is that each tends to stick with only one time frame, the one which works best for him.Each professional has his own unique way to identify potential trades. He enters the market when his plan dictates. He follows the direction of the market in his time frame rather than anticipate a change in trend.The pros are all ruthless in getting rid of losing positions. You have little to lose and a great deal to gain by exiting losers as quickly as possible. The problem is that this approach results in many small losses. The amateur wants as few losses as possible because to him, they are a sign of failure.The professional has learned to handle the inevitability of losses. He knows he can never avoid them. He pays almost no attention to losses unless they become bigger than permitted under his overall trading plan. There is little ego involvement for the professional in his next trade. He will seldom let his ego interfere with abandoning losing positions.For all traders there is a continuum between 0 percent mechanical trading and 100 percent mechanical trading. (You can also think of the continuum as going from 100 percent to 0 percent judgmental trading.) Someone who trades 100 percent mechanically never has to make any trading decision. He has a plan which tells him precisely what to do in any situation. All he has to do is monitor market activity, determine what actions his plan requires and then place the required orders with his broker. Most often, these plans are computerized. The trader inputs market data and the computer program tells him what to do.At the other end of the spectrum, someone who trades 0 percent mechanically has no fixed rules whatever. He makes every trading decision on the spur of the moment without any particular guidelines except his own idea of what will work best. Although he attempts to learn from previous mistakes, he will be unsuccessful at doing so because correct decisions do not always result in profits and incorrect decisions do not always result in losses.The emotionalism of trading can only be truly appreciated by those who have tried it. The effects of fear and greed are remarkable. Human nature is such that left to your own devices, these twin villains will invariably cause you to make the wrong decisions in the speculative arena. The most outstanding trait of professional speculators is that they have learned to control their fear and greed. They do this through self-discipline, which of necessity means their decision-making has a certain structure.I believe that successful traders all have a relatively mechanical approach even if they do not know it themselves. Therefore, all professional traders are grouped in the top half of the mechanical trading continuum. Most amateurs, on the other hand, will be found in the bottom half. Many professional money managers have a system which is 100 percent mechanical. Those who do not operate 100 percent mechanically usually allow only a small amount of personal judgment to override their system.The average person has the best chance to be a profitable trader if he or she adopts a 100 percent mechanical approach. If profit is your goal rather than massaging your ego or having fun, I recommend that you find one or more good mathematical systems and trade them in a diversified group of markets. You will also need sufficient capital and courage to withstand the inevitable equity drawdowns which occur regardless of trading approach.Here is what I mean by a strictly mechanical approach. You will have a predetermined group of markets which you will follow. You will have mathematical formulas to apply to previous prices which will tell you when to buy and when to sell. There will be entry rules, exit rules for losing trades and exit rules for profitable trades. There will be rules for when to start trading and stop trading each system. Your only tasks will be to choose initially the systems and markets to trade, to apply the system rules to market price action and to decide how to spend the (hopefully) resulting profits.If your system is computerized, you will have to provide data to the computer, run the system software and place the orders the system dictates. This should not take very much of your time. You can hire someone else to do it for you if you want. My broker has my computerized systems and places the orders for me. I run the systems myself every day to keep track of what is going on. However, I do not have the responsibility to place the orders. I can travel or take a vacation without worrying about missing something.Not only have I been successful, but I believe I have been more successful than I would have been choosing my trades with more of my own judgment. If you are truly trading commodities to make money rather than have fun, give my 100 percent mechanical approach some consideration.

Implementing A Mechanical Approach to Trading CommoditiesIn my article in the last issue of Trader's World, I argued that "The average person has the best chance to be a profitable trader if he or she adopts a 100-percent mechanical approach." This is the only surefire way to minimize the emotional influences that inevitably destroy nearly every trader. I know that in my own case, the more mechanical I am, the better my results are. Assuming you have decided to try the 100-percent mechanical approach, how exactly should you proceed? You would think that the most important step would be to find the perfect system. Strangely, finding the system is only a small part of the job. In the first place, you must abandon the idea that you will ever find the "perfect" system. The perfect system this month may be lousy next month. It will definitely have many difficult periods. A system can only exploit one time frame at a time. (What traders think of as a non-trending market is really a trending market in a shorter time frame.) There is no indicator now, and there never will be one, that can predict what type of market you will have in the future. You can never know which time frame will be optimal to trade in the near future. The best an indicator can do is tell you what type of market you are in now. You should pick a system that has done a good job historically over a long period of time. You hope and expect that if you trade it long enough in the future, you will eventually achieve approximately the same level of profitability.One key to success is to diversify as much as your capital will allow in markets and (perhaps) time frames. Up to about $50,000 in capital, I suggest you pick a relatively long-term system and use your diversification power to diversify in markets only. One system should be enough, but there is nothing wrong with trading several systems using different markets. If you have more than $50,000, you can begin to think about adding additional systems to diversify into shorter-term time frames.Long-term trading is the most efficient. In long-term trading, you hold winning trades longer, so your average profit per trade will necessarily be larger than in short-term trading. As your time frame becomes shorter, your holding period becomes shorter and your average profit per trade becomes smaller and smaller. However, your costs of trading (slippage, commissions and the bid/asked spread) stay the same. Thus, your system has less margin for error. A long-term system may give you an average trade of $500 to $2,000. A short-term system may yield an average trade down to $50. If, because of adverse market conditions, your system's efficiency decreases by $500 per trade, your long-term system may still make money, but your short-term system will be in big trouble. [To the extent that you may need intraday quote equipment for very short-term trading, your general overhead increases as well. This may or may not be offset by an increased number of trades creating additional profit.]The purpose of diversifying into a shorter-term time frame is to smooth out the equity curve by being able to take advantage of periods when the markets are congesting in your long-term time frame. Trading shorter-term can also make better use of capital if your system can move from market to market seeking the best opportunities.Depending on your trading personality, you may prefer to use additional capital to diversify in long-term systems or just add additional contracts in the markets you are already trading. I believe this approach offers the highest probability of making long-term profits and the highest expected value of profits earned. The key to benefitting from the long-term statistical advantage is to trade a well-selected group of diversified markets and to have the discipline and courage to keep trading your system until you reach the long-term.Almost all traders fail to exploit the statistical advantage of following trends in the futures markets. They do not trade their system religiously, they choose a poor group of markets to trade or they overtrade their capital and are forced to quit too soon. An essential thing to avoid is trading with an over-curve-fitted system. Nearly every system is curve-fitted to some extent. The minute you test an idea and then change it at all to improve performance, you have engaged in curve-fitting. The more you bend your system around to improve performance on past data, the less likely it is your system will trade profitably in the future. This is very hard for inexperienced traders to accept. They expect that methods which worked well in the past will probably work well in the future. Past performance will only approximate (and I emphasize approximate) future performance to the extent the system is not over-curve-fitted.The best way I know to guard effectively against over-curve-fitting is to make sure your system works in many markets using the same parameters. Successful system traders use the same system parameters for each market no matter how counter-intuitive this seems. The more markets and the longer the historical time period your system can trade profitably, the more robust it is. But don't expect your system to trade all markets and all time frames profitably. This will not happen. I trade one of my systems in fourteen markets using the same parameters for each. So long as a system tests well over a large number of markets, there is no requirement that you trade it in all of them to diversify. You could have ten systems that all tested profitably in fifteen markets over the last six years and choose to trade each of them in only one market. That would allow you to trade ten diverse markets using a non-curve-fitted system in each. It would be just as acceptable theoretically as trading one of those systems in the same ten markets.For myself, I am not concerned about finding the perfect system. I want to trade a good system, an adequate system that is not over-curve-fitted. I then spend considerable time choosing a good portfolio of markets to trade. I will discuss that process in my next article.

Chaos Theory and Market Reality, Part OneWhen a new trader examines the trading problem, his first reaction is that in order to be successful, he must learn to predict the markets. Minimum research will teach him that you use fundamental analysis to make long-term predictions and technical analysis to make short-term predictions. If our new trader examines commodity market price history, he finds what appear to be repetitive patterns. Over the long term, the markets move up and down in broad cyclic waves. If he looks carefully, he can find certain short-term chart patterns that occur over and over. Once he discovers the world of mathematical indicators, he finds that certain configurations of the indicators and price patterns repeat themselves--often at major tops and bottoms.At the same time as he is discovering these repetitive patterns of various types, he is also learning to appreciate the incredible profits that are possible if one takes action at the right time.It should not be surprising that our eager beginner concludes that the markets are entities that keep repeating themselves over and over in various ways. If he or she can learn the patterns and cycles, large profits should be easy. Maybe the markets are so organized that they repeat themselves perfectly over and over in a highly disguised way. If our trader can crack this secret code, not only will huge profits be possible, he or she can eliminate almost all losses.Our trader pursues these goals using the available literature. Profits are usually elusive. Eventually, the mail brings offers of special systems that do in fact take advantage of these patterns known only by a select group of insiders. Since these systems are often priced in the thousands of dollars, our trader assumes they must in fact be valuable trading tools. These system brochures often contain stories of legendary or reclusive traders who discovered secrets of the markets and made millions. Through various means, the seller has acquired these secrets which he now agrees to share with only a few lucky traders. These stories reinforce the belief that the few traders who are making the big money are successful because they have discovered something about market behavior that only the insider super traders know.In spite of the abundance of such prediction methods in books, systems and software, during any given year about 75 percent of commodity traders lose money. In the long run, probably 95 percent of traders lose. Nevertheless, almost no traders question the proposition that exploitable, repetitive price patterns exist. We saw a recent article titled "The Magic of Charting Price Patterns and Projections." There was nothing in the article itself that showed any performance, much less "magic."People are naturally succeptible to wishful thinking. They believe what they want to believe in spite of obvious evidence to the contrary. Short-term luck causes many such faithful traders to reinforce their invalid beliefs. In a recent interview, I was asked what is the greatest skill a trader can possess or develop. My answer was as follows: "There are obviously a number of different skills that a trader needs in order to be successful. They are all important. If I had to to pick just one that is most important, I would say it is the ability to perceive true reality."Unsuccessful traders have a distorted view of the markets, themselves and what they are really doing when they trade. It is very difficult for them to shed these misconceptions so they are doomed to long-term failure."The whole market universe is constructed in a way that reinforces their misconceptions. This compounds the challenge of overcoming them."Enter Chaos Theory. It turns out that it is possible to examine historical market price action with mathematical and statistical tools and determine whether such repetitive patterns and cycles exist.According to respected authorities, the markets are non-linear, dynamic systems. Chaos Theory is the mathematics of analyzing such non-linear, dynamic systems. Chaos analysis has determined that market prices are highly random with a trend component. The amount of the trend component varies from market to market and from time frame to time frame. A concept involved in chaotic systems is fractals. Fractals are objects which are "self-similar" in the sense that the individual parts are related to the whole. A popular example is a tree. While the branches get smaller and smaller, each is similar in structure to the larger branches and the tree as a whole. Similarly, in market price action, as you look at monthly, weekly, daily and intraday bar charts, the structure has a similar appearance. Just as with natural objects, as you move in closer and closer, you see more and more detail.Another characteristic of chaotic markets is called "sensitive dependence on initial conditions." This is what makes dynamic market systems so difficult to predict. Because we cannot accurately describe the current situation and because errors in description are infinitely compounded in the future by the system's overall complexity, accurate prediction becomes impossible. Even if we could predict tomorrow's stock market change exactly (which we can't), we would still have zero accuracy trying to predict only 20 days ahead.A number of thoughtful traders and experts have suggested that those trading with intraday data such as five-minute bar charts are trading random noise and thus wasting their time. Over time, they are doomed to failure by the costs of trading. At the same time these experts say that longer-term price action is not random. Traders can succeed trading from daily or weekly charts if they follow trends. The question naturally arises how can short-term data be random and longer-term data be deterministic in the same market. If short-term (random) data accumulates to form long-term data, wouldn't that also have to be random?As it turns out, such a paradox can exist. A system can be random in the short-term and deterministic in the long-term. The trachea in human lungs are an example in nature of just such a system.For those willing to plod through some fairly technical, jargon-loaded language, I recommend Edgar Peters' two books on Chaos Theory and the markets, Chaos and Order in the Capital Markets (992) and Fractal Market Analysis (1994). Both are published by John Wiley & Sons.In my next article I will explore this subject further and suggest some practical applications

The Correct Way to Optimize Commodity Trading SystemsIn previous articles in this space I have made the case that the average person has the best chance to be a profitable trader if he or she adopts a 100-percent mechanical approach. This is the only surefire way to minimize the emotional influences that inevitably destroy nearly every trader. It is also the only way to know whether your method has been profitable historically. Abandon the idea that you will ever find the "perfect" system. The perfect system this month may be lousy next month. It will definitely have many difficult periods in the future. Just as every trader and every methodology has losing periods, every system, no matter how brilliantly created, will encounter periods of market price action it cannot trade successfully. Thus, I am content with a good system. I define a good system as one that has a low enough drawdown and sufficient profitability in hypothetical historical testing to satisfy me as well as being robust enough to trade many markets profitably using the same parameters.In creating a system, the designer must not fall into the trap of over-curve-fitting the system to back data. The more you bend your system around to improve performance on past data, the less likely it is your system will trade profitably in the future. This is very hard for inexperienced traders to accept. They expect that methods which worked well in the past will probably work well in the future. Past performance will only approximate (and I emphasize approximate) future performance to the extent the system is not over-curve-fitted.The best way to guard effectively against over-curve-fitting is to make sure your system works in many markets using the same parameters. Successful system traders use the same system parameters for each market no matter how counter-intuitive this seems. If you doubt me, read the two "wizards" books by Jack Schwager. Jack himself manages money using systems that employ the same parameters for each market.The more markets and the longer the historical time period your system can trade profitably, the more robust it is. I trade one of my systems in fifteen markets using the same parameters for each. It is historically profitable in even more markets over the last ten years.So long as a system tests well over a large number of markets, there is no requirement that you trade it in all of them to diversify. You could have ten systems that all tested profitably in fifteen markets over the last six years and choose to trade each of them in only one market. That would allow you to trade ten diverse markets using a non-curve-fitted system in each. It would be just as acceptable theoretically as trading one of those systems in the same ten markets.That principle permits a kind optimization that will allow you trade one system using a different set of optimized parameters for each market. Those who want to optimize each market separately can do so without fear of over-optimizing.Here is the correct process. Decide which markets you may want to trade. To be safest, you should trade only markets which test profitably using the same set of parameters (the system default parameters perhaps) for at least the last five years. Let's say your system trades twenty markets profitably using the default parameters. That will be your universe for testing.You may optimize the system on each market individually. Go ahead and knock yourself out trying to maximize the profit and minimize the drawdown in each market. You will probably come up with twenty different parameter sets. Now comes the hard part. Take each one of your twenty optimized parameter sets and use it on the entire universe of twenty markets. See whether the optimized parameters hold up as well as the default parameters in trading all the other markets. If an optimized parameter set trades all twenty markets profitably, you can be confident that you have not over-optimized to the point of curve-fitting. You may use that parameter set to trade the market you have created it for.If an optimized parameter set has a hard time trading other markets profitably, that is a warning signal you have over-optimized. You should start over with the commodity it was designed for and create another parameter set that does a better job on the rest of the markets.Whether you require an optimized parameter set to trade all markets profitably that the default parameters do or just a certain percentage of them, is a question of judgment. You may want to use an optimized parameter set that trades profitably most, but not all, the markets in your universe. The more markets you require, however, the greater the chance that your system will work in the future and not just on past data.While I have described this hyper-optimization process, I am not personally convinced that it is worth the effort. I know of no evidence that suggests such individually optimized parameter sets are likely to be more profitable in the future than an unoptimized single parameter set. If it makes you feel better to show larger hypothetical historical profits, however, it probably won't hurt.When you are satisfied with the parameter sets for all the markets in your universe, you are ready to create the portfolio you will actually trade. I arrange the markets in order of profitability using the average trade as the benchmark. Then I experiment with different portfolios trying to create one with as much diversification as possible while maintaining a low maximum drawdown in relation to the average annual portfolio profit. The proper starting account size should be equal to or greater than twice the maximum historical portfolio drawdown plus the total portfolio initial margin.My software allows the portfolio selection process to be expanded even further by testing and including multiple systems in the total trading plan.

Chaos Theory and Market Reality, Part TwoIn my last article I discussed the natural progression of learning for a new trader. He or she quickly determines that in order to be successful, one must master market predicting. After reading some books in the conventional literature, he attempts to find repetitive market patterns and cycles using price bars or mathematical indicators. He may fall prey to various expensive system promotions. In spite of the abundance of such prediction methods in books, systems and software, in the long run, probably 95 percent of traders lose. Nevertheless, almost no traders question the proposition that exploitable, repetitive price patterns and cycles exist.People are naturally susceptible to wishful thinking. They believe what they want to believe in spite of obvious evidence to the contrary. Short-term luck causes many such faithful traders to reinforce their invalid beliefs. Unsuccessful traders have a distorted view of the markets, themselves and what they are really doing when they trade. It is very difficult for them to shed these misconceptions so they are doomed to long-term failure.It turns out that it is possible to examine historical market price action with mathematical and statistical tools and determine whether such repetitive patterns and cycles exist. Chaos Theory is the mathematics of analyzing systems such as market price action.For those willing to plod through some fairly technical, jargon-loaded language, I recommend Edgar Peters' two books on Chaos Theory and the markets, Chaos and Order in the Capital Markets (992) and Fractal Market Analysis (1994). Both are published by John Wiley & Sons.Chaos analysis tells us that market prices are highly random with a trend component. The amount of the trend component varies from market to market and from time frame to time frame. Short-term patterns and repetitive short-term cycles with predictive value do not exist. The patterns of prices and indicators traders use to predict occur as readily in random data. Thus, you have about as much chance to predict short-term market prices using technical analysis as you do to predict future numbers on a roulette wheel.In writing his second book Edgar Peters examined four years of tick data in the S&P. He concluded that while short-term data is not totally random, the deterministic element is so small as to be barely measurable. He concluded that "it is highly unlikely that a high-frequency [short-term] trader can actually profit in the long term." He also found that there are no cycles in intraday data.As I read the literature, this is not opinion. It is scientific fact. Traders who ignore it do so at their financial peril. Does this mean the markets are a random walk and that eventually all traders will lose because of the costs of trading? No.Traders can exploit the longer-term trend component of commodity market price action to obtain a statistical edge. This is precisely what trend-following systems do. It explains why good trend-following systems traded in diversified market portfolios tend to make money year after year while day-traders invariably lose in the long term. To be a successful speculator, you must put yourself in the same position as the house in casino gambling. On every bet the house has a statistical edge. While the house may lose in the short term, the more gamblers bet, the more the house will eventually win. If you trade with an approach that has a statistical edge and if you follow your approach rigorously (a big if), like the casino, you cannot lose in the long term.My calculation of the trading success quotient is that one-third depends on the system, one-third on the portfolio of markets traded and one-third on the trader's discipline to follow the system precisely. We can never know for sure whether our system has a statistical edge. The best we can do is create it without over-curvefitting and test it historically. If the system has been over-curvefitted, any historical testing will be pre-ordained and worthless. A simple way to guard against over-curvefitting is to use exactly the same rules for all markets and test your system on as many markets as possible. If it is profitable in a wide variety of markets in a long historical test that generates a large number of trades, it is probably not over-curvefitted.To maximize your edge while minimizing your risk, it is crucial to select an optimal portfolio for your system and account size. Since a market's price trend component is what gives you a statistical edge in the first place, you can increase your edge by concentrating your trading in markets with the highest historical trend component. I have written a book called Trendiness in the Futures Markets which is a systematic examination of the tendency of 29 popular markets to trend in all time frames between 5 and 85 days.While we can measure the various markets' tendency to trend in history, we cannot know for sure which markets will trend the most in the next six months to a year. Thus, to reduce short-term risk, we must diversify as well as concentrate. My research has shown that optimum portfolios for trend-following systems have between 10 and 20 markets. I personally trade 19 different markets with various trend-following systems.Another aspect of managing risk is keeping drawdown in relation to account size under control. Because drawdown and profitability are closely related, to reduce drawdown, you must accept smaller profits. It is impossible to evaluate the optimum portfolio for your system unless you compute the joint historical drawdown when trading the entire portfolio. I suggest a starting account size representing twice the maximum historical portfolio drawdown plus the total margin for the portfolio.Contrast this rigorous, scientific approach to the way most traders operate. They have no idea whether their methodology has a statistical edge. They assume that if it is in a book or came from a famous guru or cost a lot of money, it must be good. They trade with highly subjective methods that can never be tested. They are too lazy to create some hard and fast rules and perform proper historical testing. If this is you, don't be surprised if your trading produces losses. For you, trading may be fun, but you will pay for your entertainment.

Trend Indicators and Price ComponentsSince trading with the trend is essential to exploiting the trend component of market price action, successful systems and approaches employ some method of identifying trend. A popular idea is a separate trend filter. This is an algorithm that preliminarily looks at recent price action and determines whether the trend is up, down or neutral.It is not essential that every approach have a separate trend filter. Some methods, such as moving averages, incorporate a trend indicator into the entry technique. Others (not recommended by me) try to predict an imminent change in trend and are therefore entering when the trend is against them at the time.Many traders attempt to complicate the problem of trend identification. They invent all kinds of fancy mathematical equations and methods of massaging past price action to more precisely determine whether the trend is up or down. I have long argued that this is pointless. Like all things in trading, simplicity is the best route.Of course, trend is only relevant in conjunction with a particular time frame. But once you identify the time frame, there is nothing fancy about the concept of trend. The price is either moving up or it is moving down during that time period. You can look at a chart and in most cases quickly determine whether price is moving up or down in your time frame. Why should it be any more complicated than that? Perhaps in cases of price congestion, it is slightly more difficult to say with certainty what the trend is by quickly looking at a chart. However, this is no reason to unnecessarily complicate the trend determination process.In creating simple trend indicators, there is one intriguing issue. What price components should you use to construct the indicator? There are four choices: the open, high, low and close. You could use them separately or in combination. Can research help determine whether one or more price components does a better job of indicating trend than the others? Or are they allequivalent in trend-identifying ability?I first performed this exercise in my 1989 book, The Dow Jones-Irwin Guide to Trading Systems. The testing period there was the five-year period ending June 30, 1987. Some time ago, I thought it would be instructive to bring that research up to date.The procedure is to create four simple trend filter indicators. Each will use different price components. To test their effectiveness, I created for each a simple trading system. When the trend filter is pointing up, the system goes long. It holds the position until the trend filter reverses to down. At that point the system closes out the long position and establishes a short position. The system continues to trade that way. It is always in the market and always positioned in the direction of the trend filter. In order to make the system test as realistic as possible, I deducted $100 from each trade to cover slippage and commission. Theoretically, the filter that is most effective in determining trend should yield the highest profits as a trading system.I tested each filter in ten diversified markets over a ten- year period. The ten markets were the same I used in my book: Cattle (LC), Sugar (S), Soybeans (SB), Swiss Francs (SF), Comex Gold (GC), T-Bonds (US), Japanese Yen (JY), Heating Oil (HO), Eurodollars (ED) and the S&P 500 (SP).I used a similar approach to measure historical market trendiness in my book, Trendiness in the Futures Markets. Because the time period is so crucial in measuring trend and because I did not want to make a subjective choice, for purposes of that book I tested every time period between 5 and 85 days. I update the research every year, so the book is constantly up to date.For this limited project, I chose to use 34 days as a constant time period. From my research I have found this area to be an excellent overall trend-measuring period for all markets. It did yield profitable results for the average of all ten markets, even after deducting $100 per trade for slippage and commission.MomentumMomentum is perhaps the simplest form of trend indicator, but it is theoretically sound and ought to be psychologically pleasing. It looks at the direction of the closing price. It uses only the closing price in its calculation.To calculate Momentum, first determine the time period over which you will measure trend. Then compare today's close with the close at the beginning of your chosen time period. In this case you would compare today's close with the close 34 days ago. If today's close is lower, the trend is down. If today's close is higher, the trend is up. If today's close is the same, the trend is the same as it was the previous day.This comports with common sense. If the 34-day trend is up in the market, wouldn't you expect today's close to be higher than that of 34 days ago? Isn't that what trend means? This is a simple indicator to use while eyeballing charts. Pick your time frame and become an instant trend expert.Using the Momentum-based trading system, half the markets were profitable, and the overall average trade was $42.Directional MovementThis method of identifying trend was created by Welles Wilder and described in his 1978 book,New Concepts in Technical Trading Systems. Unlike Momentum, which uses only the closing price, Directional Movement uses only the high and the low price. It is fairly complicated mathematically, and therefore, you cannot eyeball it on charts.Directional movement compares the portion of today's price bar that moves beyond yesterday's. If today's high and low are greater than yesterday's, the portion of the today's bar that extends above yesterday's is the up directional movement. If today's high and low are less than yesterday's, the portion of the today's bar that extends below yesterday's is the down directional movement. For an inside day (where today's high is lower and today's low is higher than yesterday's), there is no directional movement. For an outside day (where today's high is higher and today's low is lower than yesterday's), the day's directional movement is the larger of the up or down directional movement as defined above. Up directional movement is positive; down directional movement is negative.To calculate the indicator, you find the total directional movement over the time period you selected for measurement. If it is positive, the trend is up. If negative, the trend is down. Just as with Momentum, the concept makes intuitive sense. If price is trending up, you would expect the preponderance of daily bars to have higher highs than the day before, and vice versa.Using the Directional Movement-based trading system, half the markets were profitable, and the overall average trade was $54.Open/Close IndicatorThis is an alternate trend indicator I created about nine years ago. It looks at the relationship between the opening price and the closing price on the same day. Thus, it has the advantage for our purposes of incorporating the opening price in the trend calculation. It is the only trend indicator I know of that uses the opening price.In an uptrending market, you will find that the close is most often higher than the open. In a downtrending market, the close tends to fall below the open. By comparing the sum of the closes with the sum of the opens over the trend time period you have selected, you get a good indication of the trend based on the relationship of the opens and closes.Using the Open/Close Indicator-based trading system, half the markets were profitable and one broke even. The overall average trade was $31.Combination IndicatorThe last test attempts to use all four available data points (open, high, low and close) to determine trend. Its indicator is the combination of Momentum, Directional Movement and Open/Close. When all three indicators (measured over 34 days) point up at once, the Combination trend is up. It stays up until all three indicators point down at once. At that point, the trend changes to down.Using the Combination Indicator-based trading system, again, half the markets were profitable, but the profits were considerably larger. The overall average trade was $185.The results of these tests indicate that the best trend indicator was the Combination. Next best was Directional Movement. Momentum was third best. Open/Close was the least effective.That such simple trend-following trading systems were profitable on average over ten diversified markets for a ten-year period shows that there is an exploitable trend component in market price action. By using a more sophisticated trading system and trading it in a more carefully chosen selection of markets, you can improve results substantially. That is precisely the way a diversified, trend-following program, such as I use in my personal trading, works.

The Best Way to Trade with Limited CapitalOne of the biggest swindles unscrupulous commodity vendors are pulling is to suggest that you can be a successful commodity trader with minimum capital. In order to sell their trading courses, they claim you can make a fortune starting with whatever amount you currently have available.Most thoughtful experts agree that there is a minimum below which success is determined by luck. I set that amount at $10,000. Below that, it is nearly impossible to apply proper risk management principles. Studies have shown that success is directly proportional to the amount of capital you have. To maximize your chances of success, it is best to have at least $75,000.My best mechanical system for small traders requires at minimum $15,000 for a conservative approach involving a five-market portfolio. Without a little luck, trading that system with limited capital may require extraordinary patience to wait for the system's statistical advantage to assert itself.If I had to trade with less than $15,000, how would I do it in a way that would maximize my statistical advantage? My suggestion is to pick a few classical chart patterns and specialize in trading with them. You must have discipline and patience to wait for the patterns to develop correctly using only markets suitable for small accounts. Additionally, you must apply strict risk management and have great tenacity to let your profits run on the good trades.Mid-America Exchange mini-contracts are a viable alternative for small accounts and highly recommended. Full-size contracts would occasionally be all right in such markets as Gold, Cotton, Soybean Meal, Soybean Oil and Oats.The best book on chart pattern trading in futures is Peter Brandt's Trading Commodity Futures with Classical Chart Patterns [available from Reality Based Trading Company]. Peter has been earning his living trading this way for over 25 years. His entry approach is to identify clearly defined chart patterns as described in the Edwards and Magee classic, Technical Analysis of Stock Trends, with a "measured move" representing a profit potential of at least $2,000 per contract and a reward/risk ratio of at least 3 to 1.There are some further requirements described in his book. For those who want to follow and learn from Peter's trading, he publishes a newsletter called The Factor (719-471-6898).Another successful expert who uses chart patterns for entry is Steve Briese, publisher of theBullish Review (612-423-4900). This excellent newsletter reports on and analyzes the CFTC Commitments of Traders reports. Steve's personal trading approach is to concentrate on only two kinds of patterns. Here's how he described his method in an extensive, exclusive interview available from Reality Based Trading Company.II continue to believe that using standard chart patterns is a very lucrative way to trade. I've gone back to look at what has worked and tried to reduce the chart patterns down to a manageable few. The first is a failure swing top or bottom, which may be a double top or bottom or the last part of a head and shoulders or triple top or bottom. These are reversal-type patterns.The other one is a coil. That would include any type of triangle which is a consolidation. It is typically a continuation pattern, but it can also be a reversal pattern.The problem with these patterns is that to trade a breakout and put your stop on the other side of the pattern usually creates more risk than I want to take and that most traders should take based on their account size. The typical approach to this would be to trade the breakout when it comes, but to put your stop at a money risk distance from the entry.I take the opposite approach. First, I determine where my stop-loss should be based on the pattern. I want to put my stop at the point where the pattern fails. Then I determine how much I'm willing to risk on the trade. In my case I never risk more then $500 per contract on any trade. I don't trade the S&P, where that would be difficult.After I've established my stop, I know what the exit point will be. Now I have to find the entry point that will keep my risk within the required amount. This will usually be at a point before a breakout verifies the pattern, still within the pattern. I use the Commitments of Traders data to forecast which way a pattern is going to complete.

I continue to believe that using standard chart patterns is a very lucrative way to trade. I've gone back to look at what has worked and tried to reduce the chart patterns down to a manageable few. The first is a failure swing top or bottom, which may be a double top or bottom or the last part of a head and shoulders or triple top or bottom. These are reversal-type patterns.The other one is a coil. That would include any type of triangle which is a consolidation. It is typically a continuation pattern, but it can also be a reversal pattern.The problem with these patterns is that to trade a breakout and put your stop on the other side of the pattern usually creates more risk than I want to take and that most traders should take based on their account size. The typical approach to this would be to trade the breakout when it comes, but to put your stop at a money risk distance from the entry.I take the opposite approach. First, I determine where my stop-loss should be based on the pattern. I want to put my stop at the point where the pattern fails. Then I determine how much I'm willing to risk on the trade. In my case I never risk more then $500 per contract on any trade. I don't trade the S&P, where that would be difficult.After I've established my stop, I know what the exit point will be. Now I have to find the entry point that will keep my risk within the required amount. This will usually be at a point before a breakout verifies the pattern, still within the pattern. I use the Commitments of Traders data to forecast which way a pattern is going to complete.

The biggest problem in trading with a small account is finding reasonable stop-loss points and still keeping risk to an appropriate level in relation to your account size. Since strings of losses are inevitable regardless of your approach, you must control risk so you are not wiped out by consecutive losers. Experts agree that for proper risk management, you should limit risk to no more than about one percent of your account equity. This is impossible with a small account.Steve Briese has been successful with stops under $500. Peter Brandt's average loss is generally under $400. You must be patient to wait for entries that qualify under your rules where you can place an intelligent stop at a point which will limit risk to less than $400-500. If the current volatility is too large to accomplish this, you must pass the trade.While novice traders spend all their time working on entries, seasoned traders know that the really difficult decisions in trading involve exiting profitable positions. Letting profits run on good trades is absolutely essential to long-term success.I believe that judicious trailing stops are the best way to let profits run. On multiple contract positions Steve Briese uses a combination of trailing stops and volatility. Peter Brandt prefers exiting at pattern objectives.While successfully trading commodities with limited capital presents the highest challenge in trading, you can do it if you recognize the problems and construct a trading plan to accommodate the realities.

How To Trade With The TrendThere are four cardinal principles which should be part of every trading strategy. They are: 1) Trade with the trend, 2) Cut losses short, 3) Let profits run, and 4) Manage risk. You should make sure your strategy includes each of these requirements for success.Trade with the trend relates to the decision of how to initiate trades. It means you should always trade in the direction of recent price movement.Mathematical analysis of commodity price data has shown that these price changes are primarily random with a small trend component. This scientific fact is extremely important to those desiring to pursue commodity trading in a rational, scientific manner. It means that any attempt to trade short-term patterns and methods not based on trend are doomed to failure.A good example of such a doomed method is Japanese Candlestick patterns. This theoretical conclusion is consistent with my previous research. Many years ago, just as Candlesticks came into vogue, I attempted to create a profitable trading system incorporating Candlesticks. I tried many patterns and many types of systems, all without success. I have never seen anyone else demonstrate the effectiveness of Candlesticks using objective rules either. Successful traders use a method that gives them a statistical edge. This edge must come from the tendency of commodity prices to trend. In the long term you can make money only by trading in synch with these trends. Thus, when prices are trending up, you should only buy. When prices are trending down, you should only sell.While this important principle is well-known, traders violate it surprisingly often. They are looking for bargains so they prefer to try to buy at the very bottom or sell at the very top before new trends become established. Winning traders have learned to wait until a trend is confirmed before taking a position consistent with that trend.Here's what consummate market expert Jake Bernstein said in my book, The Four Cardinal Principles of Trading: "Of all the common market principles, I put 'Trade With The Trend' at the very top. It's a lesson I've had to learn and relearn practically every year. All traders have the tools to find trends. That's what makes it especially frustrating when we go contrary to the trend or when we try to pick tops and bottoms."The alternative to trend following is predicting. This is a trap that nearly all traders fall into. They look at the commodity trading problem and conclude that the way to be successful is to learn how to predict where markets will go in the future. There is no shortage of people willing to sell you their latest prediction mechanism. We all want to believe that predicting is possible because it's so darn much fun to make a prediction and be right.Here's Jake Bernstein again with a little dose of reality: "It took me over nine years to realize that, although it may be a romantic and ego-satisfying goal, forecasting is not necessarily synonymous with profit. To anticipate trends is a difficult and often haphazard task, and it tends to lead to losses more often than profits."Trading with the trend is hard to do because a logical give-up exit point will be farther away, potentially causing a larger loss if you are wrong. This is a good example of why so few traders are successful. They can't bring themselves to trade in a psychologically difficult way.You can define the concept of trend only in relation to a particular time frame. When you determine the trend, it must be, for example, the two-week trend or the six-month trend or the hourly trend. So an important part of a trading plan is deciding what time frame to use for making these decisions. While it is perhaps easier psychologically to keep the time frame short, the best results come from longer-term trading. The longer you hold a trade, the greater your profit can be.Here's what Russell Sands said in an interview with Commodity Traders Consumer Report. Russell was an original member of Richard Dennis' Turtles group and has built a successful career as a money manager and advisor generally using the Turtle methodology."The best approach is to be a long-term trend follower. Trend following is statistically valid in the sense that everybody has tested it for years and years, and it works. "I acknowledge that the market trends maybe 20 percent of the time and chops back and forth in consolidation 80 percent of the time. The trick is how to define where the trend starts and where it stops. If when a market does trend, you get in at the right time, ride that trend and then get out at the right time, you'll make enough money to more than offset the losses you take during non-trending periods."Another part of the basic philosophy is that we don't know when the market's going to trend and when it's not. In fact, we don't know what the market's going to do at all. We can't predict anything it does. We don't believe in predictions. Instead, we react to the market."For the greatest chance of success, your time frame to measure trends should be at least four weeks. Thus, you should only enter trades in the direction of the price trend for the last four weeks or more. A good example of a trend-following entry rule would be to buy whenever today's closing price is higher than the closing price of 25 market days ago, and sell whenever today's closing price is lower than the closing price of 25 market days ago.When you trade in the direction of this long a trend, you are truly following the markets rather than predicting them. Most unsuccessful traders spend their entire careers looking for better ways to predict the markets. If you can develop the discipline to measure trends using intermediate to long-term time frames and always trade in the direction of the trend, you will make a giant step in the direction of profitable trading.